Welcome to the July edition of the Burrell Blog for 2017.
Portfolio Settings to commence 2017/18 financial year
The last week of June saw several articles confirmatory of portfolio settings for the commencement of the 2017/18 financial year.
Dr John Edwards, senior economist and former Reserve Bank board member penned an article noting “borrowers could be hit with at least eight consecutive official interest rate hikes in 2018 and 2019 if the economy rebounds as the Reserve Bank of Australia anticipates”. Warning that the “time is coming to get back to normal” monetary policies, Dr Edwards said the current cash rate is “way below where it will need to be in years to come”. “Normalisation means lifting the official cash rate by 2% points to 3.5%. Dr Edwards said history shows that monetary policy tightening episodes are not “necessarily gentle or gradual”.
The real focus for investment markets are the longer term rates. The ten year bond which has averaged over 6% in Australia fell to generation lows between the Global Financial Crisis (GFC) and October 2016, where it appears to have finally bottomed around 1.8%. The Australian 10 year then rose by 1% from early October 2016 to mid-December 2016. From that level of 2.8%, it drifted down to 2.35% on 20th June 2017, rebounding to 2.6% on the 30th of June 2017. US ten year Treasury notes followed a similar trajectory closing the year at 2.28%.
While the pace of interest rate tightening remains open to considerable debate, there is a clear sense longer term rates have most likely bottomed & will show a gradual uptrend for several years to come. Just as Australian rates were dragged lower by US rates post GFC, it is likely Australian rates will be dragged up by US rate increases, notwithstanding the Australian economy is at an earlier point in the full employment cycle.
There are two key implications of these rate changes:
- ↗ With ten year rates well below long term averages, the risk of capital losses on long dated bonds is a risk Burrells would prefer to avoid. Fixed interest investors should look at shorter dated securities less than three years on a fixed basis or floating rate notes if longer term is preferred. This may be a replay of 1993-94 when bond rates rose resulting in capital losses on bonds.
- ↗ The risk free rate is a key building block in valuing other securities including listed property trusts (LPT’s) and equities. While the consensus is for a gradual increase in longer dated interest rates, the interest rate headwind means investors should be careful of listed property trusts (LPT’s) and equities trading above intrinsic value.
The LPT index fell from 2400 prior to the GFC to around 600 in 2009. It has gradually recovered although not in a straight line to close 30 June 2016 at 1311.
LPT’s have an intrinsic value equal to the net assets of the underlying properties. Where the LPT is stapled to a funds management or development business, some additional value should be added for those complementary businesses. Analyses indicates that several of the larger LPT’s are trading materially above intrinsic value and ipso facto the index is trading above intrinsic value. A recent visit to our offices by Schroders indicates they are carrying no LPT’s because they see the sector as overpriced and acting as a bond surrogate ie. The price of the LPT’s was pushed up as long term bond rates fell. As this reverses, Schroders are concerned there may be capital losses on LPT’s. Burrells agree with this view and have been lightening selected LPT’s and reducing index exposure.
US Stock Market
While advisors and commentators like to comment on international markets, in fact we are dealing with a set of overseas markets for individual countries and their correlation (r-squared) is not as high as might be thought. Clearly during a global credit event such as the GFC in 2007/2009, all markets tend to be impacted and move somewhat together. However the starting point is to say the US stock market has as a main driver the US economy, the European stock market the European economy and the Australian market, the Australian economy. There is an overlay for international trade, but the starting point is the domestic economies. As noted in the previous blog, the conclusion from the Russell conference was that the US stockmarket is “very expensive”, but economic growth and sentiment were more neutral factors.
A trio of Federal Reserve officials in the US delivered cautionary remarks during the last fortnight of June 2017 concerning asset valuations in the US stockmarket. Federal chair Janet Yellen said asset valuations “looked high”; San Francisco president John Williams said the stock market “seems to be running very much on fumes” and that he was “somewhat concerned about the complacency of the market”. Fed vice chair Stanley Fischer suggested there had been “notable uptick” in risk appetite that propelled valuation ratios to very elevated levels. The price of “risky assets”, Mr Fischer said, had increased in most major asset markets in recent months including equities, which now stand in the top quintile of historical distributions.
Consistent with the view of economists that are concerned about asset prices in the US and seeking to jawbone such prices down, the International Monetary Fund cut its growth forecast for the US economy to 2.1% for 2017 and 2018, dropping its assumption that President Donald Trump’s tax cut and fiscal spending plans would boost growth. The White House has an aspirational target of increasing GPD growth to 4%, but the IMF are having none of it and seeking to remove this support for US stock market prices.
In a previous blog your diarist commented that the Reagan year saw an 8-10% increase on election and then a 20% fall as it took longer to deliver promises and that the material tax cuts in the Reagan era were not delivered until the fifth year ie. The first year of the second term. The view that there may be déjà vu between the Trump and Reagan stock market performance seems the more probable outcome to your diarist.
A number of international fund managers have similar views and are carrying higher levels of cash than usual in international managed funds. Likewise the Burrell World Equities Trust (BWET) is carrying around 20% cash and has sold down high PE US stocks. This is not to say that all valuations in the US are high. General Motors can be purchased on a PE of 6, presumably on the mistaken view that General Motors doesn’t know how to make electric cars. There also appears a reasonable demand for Raytheon rockets and missile defence systems.
During the technology bubble in 2000, the US market moved well above the Australian market which continued at a modest trajectory. The result was that the Australian market did not move adversely during the technology bubble during the years from 1998-2001, but incurred a modest fall during the 2002 year as some Australian stocks including Melbourne IT failed to deliver on investors who bought the stock with rose coloured glasses thinking the company owned the internet.
The Australian market has performed in a similar manner to that period, not participating to any large extent in the technology stock appreciation for the likes of Amazon, Netflix and most recently Snap Inc (Snapchat). Snap listed on a valuation of $1.2B, even though revenue is only $800M. In Australia we have seen stocks on high valuation multiples correct quickly on any disappointment eg Blackmores falling from a high of over $200 to an attractive level under $90 in the second last week of June. The question is whether the US market might similarly correct on a sector basis, which seems the modus operandi in Australia.
The dividend yield driver is alive and well in Australia with strong dividend yields likely to continue to underpin the Australian market, such that no dramatic collapse is anticipated.
In the last two months of the financial year, Australian banks corrected after the Federal Budget due both to the sentiment around the bank tax and more likely overseas concerns around the property market (appear over done) and uncertainty in advance of the final new capital requirements for banks. The bank correction has likely factored in these risks, but those preferring to wait until the new capital requirements are known and this risk is behind us, are following a reasonable strategy.
In summary, longer term interest rates have most likely bottomed, suggesting fixed interest investments should be kept shorter or floating rate. The LPT sector in Australia has been a useful source of realised profits in the 2017 June financial year. Selective holdings in this sector based on careful research are the likely strategy going forward into 2017/18. US equity markets appear fully valued on average, so selective investing is recommended rather than US indices/exchanged traded funds (ETFs).
Overall, it is recommended that investors carry higher levels of cash than normal and be prepared to grin and bear the lower earnings rates until there is some correction in the valuation issues noted above.
X Factors are geopolitical with North Korea a 20-25% probability of military confrontation. That is your diarist’s probability. A sharp correction to US valuations similar to the tech bubble correction is also a possible X Factor.
Your diarist will now take a short break to recover from 30th June and convince himself to do it all over again!
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This document contains general securities advice only. In accordance with Section 949A of the Corporations Act, in preparing this document, Burrell Stockbroking did not take into account the investment objectives, financial situation and particular needs ('relevant personal circumstances') of any particular person. Accordingly, before acting on any advice contained in this document you should assess whether the advice is appropriate in the light of your own relevant personal circumstances or contact your Burrell Stockbroking advisor. If the advice relates to the acquisition, or possible acquisition, of a particular financial product, you should obtain a Product Disclosure Statement relating to the product and consider the Statement before making any decision about whether to acquire the product.
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